Installment Sales. Installment Method under Section 453 Allows for a gain on sale as well as the accompanying tax liability to be deferred

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1 1 Installment Sales

2 2 Ordinarily recognize gain or loss when property is sold under section 1001 Amount realized less adjusted basis Typically, the entire amount of the sale or exchange will be recognized Taxable income is computed under the taxpayer s regular method of accounting Cash or accrual method Or other permissible method

3 3 Installment Method under Section 453 Allows for a gain on sale as well as the accompanying tax liability to be deferred Gain is spread over the period during which the payments are received Pro rata share of each principal payment is treated as recovery of capital/basis The remaining share of each principal payments is gain Does not apply to sales at a loss Changes the timing of income, not the total amount of income

4 4 Installment Sale: a disposition of property where at least 1 payment is to be received after the close of the taxable year in which the disposition occurs. No requirement that any payment be made in year of disposition No prohibition on using the installment method even if a substantial percentage of the total payments is received in the year of disposition

5 5 Cannot be used for: Sales of publicly traded stock or securities Personal property included in inventory Sales pursuant to a revolving credit plan Dealer dispositions, generally Includes real property held for sale to customers in the ordinary course of business But, not to property used or produced in farming, or Certain sales of residential lots or time shares

6 6 Three Parts to an Installment Payment Interest Income Return of Adjusted Basis Gain on Sale Installment Payment Interest Income is reported as ordinary income Adjusted Basis is comprised of: Adjusted Basis, Selling Expenses, and Depreciation recapture. Character of Gain: What was the holding period and is it a capital asset?

7 7 Stated Interest Adequate Stated Interest: when the contract s stated principal amount is at least equal to the sum of the present value of all principal and interest payments. The present value is based on the Test Rate of Interest Test Rate of Interest: The lowest AFR over a 3-month period based either on the date of the date the contract becomes binding or when the sale or exchange has taken place. Unstated Interest When the installment sale contract does not provide for adequate stated interest. Part of the stated principal amount will be recharacterized as interest. Unstated interest is reported as income. Either Section 1274 or 483 will apply

8 8 Amount of Gain to be Recognized When Payment Received Gross Profit Ratio X Payment Received Gross Profit Ratio: Gross Profit Total Contract Price Ratio percentage stays consistent even if the payment amounts vary to determine the taxable amount

9 9 What Is Gross Profit? Gross Profit = Selling Price less Adjusted Basis Selling Price = Gross Selling Price plus any mortgage or debt liability assumed by buyer Does not include stated or unstated interest May also include selling expenses assumed by the buyer What Is Contract Price? Contract Price = Selling Price less Qualifying Indebtedness Installment sale recognized in any year is that proportion of the payments received in that year which the gross profit (realized or to be realized when payment is completed) bears to the total contract price. 453(c); Reg. 15A.453-1(b)(2)

10 10 Qualifying Indebtedness A mortgage or other indebtedness encumbering the property Debt relief is generally not treated as payment but as qualifying indebtedness per Treas. Reg. 15A.453-1(b)(2)(iv) Mortgage relief is treated as a tax-free return of basis Gross profit amount will remain the same but the amount of the payments and the contract price will be decreased by the amount of the mortgage relief Excess liability: the amount by which qualifying indebtedness exceeds the basis Entire basis is recovered and excess is treated as a payment

11 11 Example: Buyer Assumes Mortgage Cash Payment ($2,000 now, and $2,000 in each of the next 4 years) $10,000 Plus: Mortgage Assumed by Buyer 15,000 Selling Price $25,000 Selling Price $25,000 Minus: Mortgage Assumed by Buyer 15,000 Contract Price $10,000 Adjusted Basis $19,000 Plus: Selling Expenses 1,000 Installment Sale Basis $20,000 Selling Price $25,000 Less: Installment Sale Basis 20,000 Gross Profit $5,000 Gross Profit Ratio = Gross Profit Contract Price = $5,000 $10,000 = 50% Example from IRS Publication 537: Installment Sales

12 12 Transactions with Related Persons Second Dispositions by Related Persons Related persons as defined by Sections 318(a) and 267(b) Acceleration of the recognition by the initial seller of the installment gain Limitation: Only applies to second dispositions occurring within 2 years of the initial installment sale Does not apply to an involuntary conversion of the property Does not apply if the principal purpose was not for the avoidance of taxes Sales of Depreciable Property to Related Persons Installment method generally not available Related persons per 1239(b) controlled entity, trust with the taxpayer or spouse as beneficiary, or executor of an estate and the beneficiary of the estate deferral under 453 ends when the taxpayer disposes of an installment obligation

13 13 Contingent Payment Sales Property s selling price is made contingent on future events No ascertainable fair market value Burnet v. Logan (1931): Open Transaction treatment - first fully recover basis in the property; once basis is recovered remaining payments would constitute taxable gain. Section 453(j)(2): prescribed regulations providing for ratable basis recovery in a situation where gross profit or total contract price is not readily ascertainable Treas. Reg. 15a.453-1(c) Methods: 1. Stated Maximum Selling Price 2. Fixed Period 3. Neither Stated Maximum Selling Price or Fixed Period

14 14 Electing Out of the Installment Method under 453(d) Elect out and report the gain on the sale in accordance with the taxpayer s normal method of accounting Must be made in a timely manner May be revoked only with the consent of the Service Cash Method: taxpayer is directed to treat the fair market value of the obligation as having been realized in the year of sale and to treat that value as not less than the fair market value of the property sold (less other consideration received) Accrual Method: taxpayer is directed to treat the total amount payable on the obligation as realized in the year of sale. Election-out cannot be used as a deferral of income technique; acts as acceleration of income

15 15 Recapture Income Section 453(i) Exception: recognition in the year of sale of any recapture income due to depreciation under Sections 1245 or 1250 Recognized currently regardless of when payments are made Recaptured amount is added to seller s basis Also includes Section 179 and 179A deduction recapture Reported as ordinary income

16 16 Dispositions of Installment Obligations 453B Tax deferral under 453 ends when the taxpayer disposes of an installment obligation To determine gain or loss, the taxpayer must subtract the basis of the obligation from either the fair market value of the obligation or the amount realized on its disposition. The character of the gain or loss will depend on the underlying property Sale or Exchange of Note Gift of Note Cancellation of Note Transfers between spouses or incident to divorce: rules of 453B do not apply Transferee steps into the shoes of the transferor Special rules apply to installment agreements transferred at death.

17 17 Installment Obligations and Like-Kind Exchanges Receipt of an installment obligation issued by the other party as boot 453(f)(6) treatment: 1. The like-kind property is not treated as a payment 2. The gross profit ratio is specially determined, with the contract price reduced by the amount of the like kind property received and the total gross profit reduced by the amount of gain not recognized under 1031.

18 18 Other Interest on Deferred Tax Property with sales price over $150,000 and total balance of all non-dealer installment obligations is more than $5,000,000. Interest on deferred tax must be paid on the obligation that arises during the tax year Exceptions: Rule does not apply to dispositions of: Farm property, Personal use property by an individual, Personal property before 1989, or Real property before Repossession Use of an Escrow Account Reporting an Installment Sale Use Form 6252

19 M. Robinson & Company, P.C. Tax Law Specialists 160 Federal St. Boston, MA (617) (c) Copyright M. Robinson & Company February All Rights Reserved.